How Paulson Used AIG To Throw Goldman Sachs A Big Old Bone

Among a lot of others, mind you.

It's in the WSJ today and branching out from there -- several of the counterparties receiving par payouts for their toxic CDOs now owned by the taxpayers have been identified. The first name on the list is Goldman Sachs:

Among those institutions are Goldman Sachs Group Inc. and Germany's Deutsche Bank AG, each of which received roughly $6 billion in payments between mid-September and December 2008, according to a confidential document and people familiar with the matter.

Other banks that received large payouts from AIG late last year include Merrill Lynch, now part of Bank of America Corp., and French bank Société Générale SA.

More than a dozen firms with smaller exposures to AIG also received payouts, including Morgan Stanley, Royal Bank of Scotland Group PLC and HSBC Holdings PLC, according to the confidential document.

This is big news because the vice chairman of the Fed, Donald Kohn, would not identify any of these companies when he appeared before the Senate Banking Committee on Thursday.

However, it was already known that Goldman Sachs, Societe, and Deutsche Bank had gotten a big payout from the AIG debacle, as this December 17 article from Business Week shows.

I've been trying to understand what happened here. Putting the Business Week article together with the Kohn testimony and this summary of part of the deal and other sources, you get a clearer idea of just how billions in TARP money has been funneled to these institutions. And it stinks.

To help explain what's happened, I've prepared a PDF presentation of this, relying mostly on Kohn's testimony. You can access it at my unrelated website here (pdf).

Let's go back a bit to when Bear Stearns went under. The Federal Reserve worked together with JPMorgan Chase to get JPMorgan a great deal. The Fed created a limited liability company in Delaware, named after the street the New York Fed bank is on, Maiden Lane. Maiden Lane, LLC, received $29 billion in loans from the Fed, and $1 billion in loans from JPMorgan. Maiden Lane used that money to buy up the toxic assets at the heart of Bear Stearns' woes. JPMorgan Chase then purchased Bear Stearns, free of the toxic assets with $30 billion sitting there all nice and tidy. And then JPMorgan bought Bear Stearns at $10 a share (although, remember, Hank Paulson wanted them to sell at $2).

Now this whole deal stunk mightily in the nostrils of Congress, and they saddled the Federal Reserve with some more strigent restrictions on how they deal out the money. And Maiden Lane, LLC, has actually lost $5 billion in value since that time. But that didn't stop them from pulling out the old playbook when AIG came staggering in through the door.

Well, what else was the Fed going to do?

AIG is actually a quite stolid and no-nonsense company for the most part. But one of its arms, AIG Financial Products (AIGFP), was described recently by Ben Bernanke:

"If there is a single episode in this entire 18 months that has made me more angry, I can’t think of one other than AIG," Bernanke told lawmakers today. "AIG exploited a huge gap in the regulatory system, there was no oversight of the financial-products division. This was a hedge fund basically that was attached to a large and stable insurance company.

What AIGFP was pretty wild. First they took out loans on stable assets owned by AIG and used that cash to invest in what would become toxic assets -- the collateralized debt obligations (CDOs) that have become so familiar to ordinary Americans nowadays. These are the complex financial instruments that all sorts of mortgages had been bundled into, sliced up, and rebundled to help minimize risk. AIGFP bought up a lot of them.

They also had friends out there doing the same thing. These companies wanted a kind of insurance on their CDO's, so AIGFP sold them credit default swaps (CDSs). This meant that AIG would be responsible for losses on the CDOs after a deductible of sorts was reached. But since they were all as safe as houses, the money being paid into AIGFP was a windfall. Money for everyone, and all granted under AIG's Triple A credit rating. Nice of them to lend that out to the underregulated, loophole-exploiting Financial Products arm, don't you think?

Of course, the housing market started to tank. And the truth is, AIG had been trying to extricate itself from this godawful mess for a while. They stopped issuing these types of deals back in 2005 when they started feeling squishy about them. They'd been working with regulators to unwind all of this mess.

But then a crisis point was reached. The counterparties who held the loans on their stable assets were starting to ask for their money back. The counterparties who'd bought credit default swaps on their toxic assets were losing cash and starting to call in their CDSs. And AIGFP had not set aside any capitalization against those CDSs -- they didn't have to! They weren't technically insurance. They were derivatives. And AIGFP was having difficulty selling their own toxic assets to meet their obligation to these two sets of counterparties.

This is the essence of a liquidity crunch. The cash has seized up. AIG needed help fast and a lot of it.

On September 16, 2008, the Federal Reserve provided AIG with a huge line of revolving credit. They created a facility with the quirky name Revolving Credit Facility. They put $85 billion inside this facility and opened up a window for AIG. This was the plan -- AIG draws on the credit as they have need to satisfy their obligations. Over time good assets get freed up and/or toxic assets become good boys and girls again. By selling these assets, AIG could then pay back the Revolving Credit Facility. And it had two years to do so, and then, poof! The Revolving Credit Facility is no more and AIG has learned a very important lesson.

And just to make extra sure that the government wouldn't lose any money in the deal, AIG had to place 79.9% of preferred convertible stock into a trust payable to the Treasury. The important thing here to know about preferred convertible stock is that if the Treasury decides to, it can convert this preferred stock into common stock, which means the Treasury really does own a massive controlling interest in AIG at that point.

So that worked, right? Not quite. By October 1, AIG had already drawn out $61 billion of the $85 billion available to it. Yes, you read that right. Two weeks later.

The toxic CDOs were getting worse and worse. They still couldn't sell their own, and the cash collateral calls from the counterparties from whom they'd borrowed were stacking up and the CDSs were mounting as well.

So the Fed took some further steps. They created a second facility for AIG, the Secured Borrowing Facility, that allowed several AIG subsidiaries to borrow up to $37.8 billion more to pay off the cash collateral calls. This was only a temporary fix, meant to buy AIG time to start selling assets and get their own cash flow running again.

Do you think it worked? Does a bear poop in the Vatican?

By November, the economic crisis was deepening and AIG was about to lose its Triple A credit rating. That would have mean immediate needs to pump up their available capital, with more collateral calls and more people bailing out of other financial arrangements. Plus, they did have this thing called actual insurance that they did occasionally like to sell to people, and that business was drying up fast as well. AIG was barely hanging on.

But by November, Hank Paulson had gotten his $700 billion in the Troubled Asset Relief Program and the wheeling and dealing had begun. Bernanke was spitting nails already about the whole situation, so the two of them got together and start thinking about restructuring the entire AIG bailout.

They came up with this. First, Bernanke capped the first facility from September, the Revolving Credit Facility, at $60 billion. He also lowered the interest rate AIG paid on this money and stretched out the loan term to five years. But AIG had to post all proceeds from asset sales into this facility and pay off the $60 billion.

Paulson agreed to give AIG $40 billion in TARP funds in exchange for $40 billion in Senior Preferred Stock in AIG. Fancy!

Then the Fed created two more Maiden Lane corporations, Maiden Lane II and Maiden Lane III. Paulson funded both of these institutions with TARP funds and then both started dealing with AIG's major problems, their own toxic assets and the CDSs on other counterparties' toxic assets.

Maiden Lane II got $20 billion in TARP funds from the Treasury. It went to the AIG subsidiaries that had been borrowing from the Secured Borrowing Facility created in October by the Fed. In exchange, the subsidiaries forked over the toxic assets they held. They were worth $40 billion at par (what AIG paid for them in the first place) but AIG only got $20 billion for them. They took the hit themselves, writing off the rest, and then paid back the Secured Borrowing Facility what they had borrowed.

And, poof! The Secured Borrowing Facility was terminated.

Maiden Lane II has 6 years to repay the TARP money to the Treasury. Its only holdings are these toxic assets bought at about 50 cents on the dollar, so the Fed is betting that the assets will at least be worth that $20 billion plus interest in six years. If there's any money left over after the Treasury is paid off, the Fed gets 67% of that and AIG gets 33%. Cross your fingers!

But it's Maiden Lane III that is the real piece of work. Keep your eye on the ball...

Maiden Lane III has been funded with $25 billion of the TARP funds (under the same terms as Maiden Lane II), and AIG was told to kick in $5 billion as well. Maiden Lane III has gone to to the counterparties that purchased the credit default swaps from AIG and given them an offer they couldn't refuse - all of their money back.

Here's how it worked. There was around $62 billion of toxic assets (at this point) being held by these counterparties. They gave them to Maiden Lane III for the grand total of $25 billion. Sounds bad, right? Sounds like they took a bad loss for buying such crazy assets in the first place, right?

AIG paid them everything else.

That's right. In exchange for terminating the CDSs they held on AIG, these counterparties received every single cent they ever paid for these crappy assets. They got par. Now it may very well be that these counterparties have more CDOs that weren't backed up by AIG's credit default swaps, and could still be in a world of hurt. But how nice was it that Maiden Lane comes along with TARP funds and brokers them a par payment on these crappy derivatives!

AIG, of course, took the hit here as well. $37 billion writeoff here, plus $20 billion writeoff because of Maiden Lane II, and $5 billion paid to Maiden Lane III... well, it's a good thing old Hank, former CEO of Goldman Sachs, plugged $40 billion extra of TARP funds into AIG, because that spectacular net loss of $62 billion in the fourth quarter could have been $100 billion.

And now we know that one of the two biggest beneficiaries of this incredible money shuffle was Goldman Sachs, which got (according to the Wall Street Journal) 10% of the money paid out through this deal.

Goldman Sachs received full par payment of their toxic assets backed up by AIG, $6 billion worth, thanks to the keeper of the TARP funds, Hank Paulson.

How is this not the definition of moral hazard, the dreaded term so hated by Paulson that he actually let Lehman Brothers collapse to avoid it? Yes, Lehman Brothers was one of Goldman Sachs' competitors, now that you mention it. They get the shaft, Goldman gets a great big bone from Paulson, AIG writes off billions, and the taxpayers are left holding the bag.

But wait, it gets better. In the Business Week December article, not all of this money had been thrown around yet. The figures are incomplete. Here, only $15 billion had come from TARP into Maiden Lane III, and with the $5 billion from AIG, Maiden Lane III had purchased only $46 billion from this counterparties at that point in time. So AIG had paid out $26 billion due to its CDS obligations.

The final numbers are $24.3 billion from TARP. Now they leave AIG's $5 billion in Maiden Lane III to guard against loss of asset value. So that left $4.3 billion to buy up $16 billion more in toxic assets. That was about 25 cents on the dollar for those assets. Yay, us. But of course AIG made up the difference to terminate the CDSs, so these companies also got par for this junk.

How are all of these assets performing in the Maiden Lane LLCs? How does Paulson justify throwing that kind of money at his old company? How much did Paulson know about these CDSs? After all, Paulson wasn't Treasury Secretary until the middle of 2006 and AIG had stopped all sales of these CDSs in 2005. In other words, Goldman Sachs got all of their AIG credit default swaps while Paulson was CEO.

Oh, by the way, Goldman Sachs did post a fourth quarter 2008 loss, $2.8 billion. They still managed to end the year with a $2.32 billion profit, though. I guess that $6 billion from the AIG situation really helped out at the end of the day.

I hope we do as well.